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The Spectrum of Hedge Fund Investors and a Roadmap to Effective Marketing

Merlin has written a number of articles and papers this year about the changing nature of the hedge fund industry. Specifically, we have written about the various requirements that funds need to meet in order to attract and reach the right investors. What we have not addressed is who those target investors are and how managers can determine the appropriate investors for their specific fund. In fact, we feel that surprisingly little has been written about this topic in the post-crisis environment. Now more than ever, it is critical that hedge funds know their investors, know what those investors require, and understand how to tailor their marketing strategy accordingly.

The hedge fund industry is experiencing a period of unprecedented uncertainty. Many existing and established funds are struggling simply to keep moving forward against redemptions and perilous market conditions. Additionally, for many managers who have launched in the past several years, while their initial goals may have been clear – get the fund up and running, build a track record and grow to the target AUM goal – the financial crisis has knocked them off course.

Many investment managers made early infrastructure investments they felt were necessary to reach their goals: they bought advanced trading, reporting and risk technology products; took up expensive space; and hired top-tier talent. They built the foundation for a significant fund platform.

Then came the financial crisis and the ensuing turbulent market. The “ready” capital these managers expected to find early in their development was invested instead with larger, more established funds with better pedigrees and longer operating histories. Additionally, the revenue they anticipated from their “2 and 20” compensation structure never materialized: the management fees suffered from smaller AUM, and performance fees suffered because the market has been difficult to navigate. Many of these funds are experiencing low single-digit returns and are still under or near their high-water marks.

For these managers – as well as other existing managers whose revenues are simply not sufficient to support their operating expenses – today’s climate necessitates difficult decisions both for the top- and bottom-lines. Critical questions that must be asked include: What expenses should be reduced? How can managers grow AUM in this environment? How can a fund meet its day-to-day obligations and pay top-tier talent when the revenues are not where they need to be?

These questions are – at their core – the most basic questions any business manager must ask. And while little good has come from the financial crisis, one positive development has been the realization among many hedge fund managers that they are not simply managing a fund – they are operating a business.

This concept, while seemingly straightforward, is the key to moving up through the various levels of potential investors.

THE SPECTRUM OF HEDGE FUND INVESTORS

The spectrum of hedge fund investors is arranged, generally, in terms of how “institutional” each type of investor group tends to be. Regardless of whether these investors are in fact “institutions,” by “institutional” we are referring to the level of general requirements each investor group places on their hedge fund managers: assets, operational practices, risk management framework, track record, reporting and so forth.

Just as the spectrum goes from risk-tolerant to risk-averse, as a general rule of thumb, hedge funds can assume that if they are ill-equipped to meet the needs of one level of investor, they are unlikely to realistically be able to target any higher, more risk-averse levels further along the spectrum.

A Closer Look at Each Level of the Spectrum

1. Partners, Friends, Family & Angels

Overview: Friends and family members are the inner circle of investors. They have close relationships with the general partner(s) of the fund, including in many instances a prior investment relationship. General partners of a fund traditionally make significant investment of their own net worth into the fund to demonstrate an alignment of interest with their limited partners.

When to access: Prior to Day 1. These investors often comprise a significant portion of a fund’s launch capital.

Advantages: The personal relationships that often exist among these investors may enable a manager to find capital without overcoming the institutional hurdle – i.e., without having a significantly developed infrastructure, team, track record and AUM. These investors will also likely require minimal due diligence and will stay with the fund through various market cycles as patient investment capital.

Challenges/Limitations: While these investors are helpful as first movers of capital, they typically make small investments. They may get a fund up and running, but they do not help achieve critical AUM – i.e., a level of assets that allows investors further up the spectrum to invest without becoming a significant portion of overall AUM.

2. High-Net-Worth Individuals

Overview: As a non-institutional group of investors, high-net-worth (HNW) individuals are accredited investors or qualified purchasers as defined by the U.S. Securities and Exchange Commission. They have the ability to invest based on referrals from personal relationships. Managers may access HNW individuals by networking with friends and family, current and past investors, executives of the companies the fund covers, hedge fund databases, consultants and third-party marketers.

When to access: Prior to Day 1 and early in a fund’s development.

Advantages: Similar to the friends and family group, these investors are often willing to invest in managers that do not satisfy the rigorous requirements of institutions and who have smaller AUMs. They should be longer term investors, typically.

Challenges/Limitations: Smaller check sizes, harder to source investors, potentially difficult to perform background and due diligence checks. Many HNW investors will require access to the portfolio management team, which can become a strain on PMs.

3. Seeders & Acceleration Capital

Overview: Investors who provide seed or acceleration capital receive compensation for their investment, often in the form of a revenue sharing agreement or equity ownership. These investors can provide Day 1 funding from $5 to $100+ million, and that capital is typically provided by one of the 20 traditional seed capital providers, other hedge fund managers, HNW individuals or private equity firms.

This capital is also often used to help spinout funds that are seeking to replicate their previous funds. Once a fund is able to secure this level of capital, they typically are at the first level of critical AUM for marketing to other investors. Acceleration capital is provided to managers who have already launched but are willing to enter into a partnership with an investor to quickly ramp up their AUM level.

When to access: Prior to Day 1, or anytime for acceleration capital.

Advantages: These investments, typically larger in size, enable a manager to reach critical AUM, which in turn opens the door to the first levels of institutional investors, especially those with lower AUM requirements.

Challenges/Limitations: While seeders are willing to invest early with managers, typically they require a revenue sharing agreement or an equity stake in the fund. Given their unique ability to invest significant capital with unproven managers, seeders are extremely sought after. They see many opportunities, but invest in few.

Overview: This group of investors requires that their investment be placed in an investor-owned account segregated from the commingled fund. The manager will act as the trading advisor to this account, and while most often traded pari passu, in some cases investors will require additional strategy constraints or risk parameters be applied to the SMA. This source of capital has enjoyed a major surge in popularity by investors and acceptance by managers following the broad market redemptions and gating of 2008. Their popularity is due to the benefits they offer to investors, including transparency, ownership of the account and liquidity through control of assets. Other investors take these benefits one step further and require managers to put up capital into a separately managed account to serve as first-loss capital, thereby creating a principal-protected account.

When to access: SMAs provide liquidity and transparency and thereby enable investors to gain comfort at any stage of the fund’s lifecycle.

Advantages: SMAs provide an additional revenue stream to support the business and help build out infrastructure. Taking capital into an SMA shows AUM growth and fundraising momentum.

Challenges/Limitations: SMAs increase the operational complexity for a manager. The assets are not invested with the commingled funds and therefore do not assist in targeting larger investors who, because of their minimum investment size, are limited by the total fund size.